Regulation and the Financial Sector - Right Direction But How Far and How Fast?

INTRODUCTION

The regulatory response to the financial crisis is of great interest not only to policymakers and those in the financial sector, but also to the wider public.

This paper, which is based on interviews with senior industry figures prior to the general election campaign, sets out some market reactions to the proposals made on capital and liquidity regulation, and on how best to deal with firms that are currently deemed 'too-big-to-fail'. As such, this paper provides input from the financial services industry into the debate underway in the UK and internationally on the new regulatory proposals. It focuses mainly on selected views of the larger banks operating in the UK.

Some of these issues were addressed in the Turner Review Conference Discussion Paper in October 2009, which focused on how far the policy response should take the form of capital surcharges, the separation of narrow banks from investment banking (or other structural changes), or recovery and resolution plans (sometimes dubbed 'living wills').

But this is only one in a torrent of proposals: one interviewee identified at least 60 papers of which his firm needed to take note, while another concluded that the 'greatest strategic issue facing bank boards around the world is regulatory change'. This report therefore considers a range of proposals on prudential regulation, and in that sense follows the Discussion Paper, which considered how the cumulative impact of these proposals should be assessed. This is of increasing relevance given the study of some of these issues recently commissioned by the new UK government.

In each section we begin by setting out the current proposals, followed by the views of those interviewed for the report.

EXECUTIVE SUMMARY

The overwhelming consensus from those we spoke to in the financial services industry was that it was essential to view the regulatory changes as a whole, and be clear about the impact of a tightening in standards not just on regulated firms but on the availability of credit in the economy.

The emphasis on capital and liquidity was understandable, but there were issues over the amount, timing and purpose of the additional buffers. Without clarity on these points, planning became much more difficult and the availability of credit could be inappropriately constrained.

The other key messages from practitioners were as follows:

In the 'too-big-to-fail' debate some feared there was still too much focus on size per se. Some narrow banks failed; diversification of risk remained vital. To them the discussion about proprietary trading largely missed the point: the real problem with the trading book was specifically what was traded and how. Timing was also important in the debate on the quality of capital and liquidity: new forms of core Tier 1 capital will take time to develop and issue, and there was a limited pool of high-quality liquid assets. It was too soon to judge the impact of a leverage ratio in addition to everything else, until more of the details had been published. There were important uncertainties and reservations about the recovery and resolution ('living wills') proposals, which (some feared) might be used by regulators to restructure the industry by stealth. As was the case for other proposals, UK institutions fear that other countries will not necessarily implement the living wills requirements as fully or quickly as the UK. 'Too-Big-to-Fail', 'Too-Big-to-Rescue' or 'Too-Interconnected-to-Fail'

These phrases encapsulate the issues which the FSA and the Financial Stability Board (FSB) are considering. Lord Turner instead used the term 'systemically important banks' in the Conference Paper, and to a lesser extent when giving evidence to the Treasury Committee.1

The range of possible solutions under consideration by the Standing Committee for Supervisory and Regulatory Co-operation (a sub-committee of the FSB which Lord Turner chairs) is wide, and includes restrictions on the breadth of activities which banks can carry out, even though his public pronouncements do not appear fully in line with the views of some of the narrow banking proponents.

Interviewees were still not clear which firms were considered 'too-important-to-fail', a matter on which regulators and central banks may, or may not, wish to remain ambiguous. The initial report of the FSB2 defined a systemic event (not an institution) as caused by an impairment of all or parts of the financial system with the potential to have serious negative consequences for the real economy. It set out three possible systemic criteria: size, substitutability (the extent to which others can provide similar services) and interconnectedness (linkages with other components of the system), but stressed the need for in-depth knowledge and analysis of financial structures and the exercise of judgement, given the lack of data and definition around 'systemic importance'.

Most participants noted it was not just the large banks, nor generally the universal banks, which had failed, but those with inadequate risk controls that had geared up their balance-sheets, often via the wholesale markets and securitisation. In the UK, HBOS, Northern Rock, Bradford & Bingley and the Icelandic banks were retail and commercial banks: the mutual sector also came under pressure. In Germany IKB, a real estate bank, had problems. In the US, Lehman Brothers and Bear Stearns, both investment banks, got into difficulty as well as Washington Mutual, a large mutual organisation; AIG (an insurance group) received extensive government support to meet non-insurance losses.

One interviewee described recent events as a 'unique collapse, in which no one was left out in the cold', and certainly many large firms, some of which would be considered systemic on any definition, received government support. Most banks, however, 'managed their way out of the crisis', albeit helped by central bank funding arrangements.

Lord Turner on separating 'socially useful' banking from 'casino' banking

'Too-big-to-fail' is therefore too simplistic a description both for the regulators and the industry. It requires a deeper analysis of the risks posed (and the impact on society) from the failure of large, complex and interconnected organisations.

In parallel, the wider issue of externalities in the financial system is now more often discussed by policymakers: how far do the activities of firms spill over onto others, and is this fully taken into account by the present regulatory arrangements? For instance, Lord Turner has raised broader questions about the structure of the financial markets, such as – in the context of exotic credit default swaps – 'Can it be proved that this is a market that has an end purpose?'3 and 'Are all categories of credit equally useful ... we certainly do not want regulators or central banks to say that this credit is good and that credit is bad' but problems with commercial real estate might require 'new tools of macro-prudential control ... which might constrain credit in certain parts of the economy even more than in others'.

Breadth of activities as well as size is important, in his view. 'There are arguments for limiting the extent to which deposit-taking banks undertake proprietary trading, which is unrelated to customer service' (a reference to the 'Volcker rule' that would separate commercial banking in the US from in–house hedge funds, private equity and proprietary trading 'unrelated to customer service').4

However, this might be achieved not through a ban but through capital requirements. In his evidence to the Treasury Committee Lord Turner explained how he had described the FSA's method to Mr Volcker of 'tracking very carefully the day-to-day trading activities of our major banks and investment banks and observe whether they are volatile or small amounts of profit with only a small tail of higher profit and loss'. Higher capital requirements would then be imposed for proprietary trading. Similarly, Paul Volcker said to the Senate: 'Banking supervisors should be able to appraise the nature of those trading activities and contain excesses. An analysis of volume relative to customer relationships and of the relative volatility of gains and losses over a period of time in the 'trading book' should raise an examiner's eyebrows. Persisting over time, the result should be not just raised eyebrows but substantially raised capital requirements'.5

"Proprietary trading is much less important than people think"

In response, some participants said it was difficult, if not impossible, to 'unpick customer driven trading from trading on one's own account', adding that the latter probably accounted for only 5-10% of the trading book. One participant argued that in some of the banks that had failed the trading operations were quite small but overly focused on the retail and real estate markets with insufficient prudence in lending or diversification of risks. In fact, he argued, the 'trading book is better situated in more diversified banks with large balance sheets', better placed to meet any losses. Another, whose bank engaged in little proprietary trading, argued that 'the principal risk' lay in 'taking a view in order to facilitate clients', which meant that the bank had to take positions. Regulators needed to make appropriate distinctions between 'proprietary risk and principal risk' (resulting from client business) though this would not be simple to achieve.

One interviewee felt that the Volcker proposals would not be carried out, but that if they were the US bank holding companies would simply move offshore to avoid them, unless the rules were adopted internationally. The lesson of the loss of the Eurodollar market had not been forgotten. He too agreed that the way to deal with risks in the trading book was through increased capital.

"A bystander at a bar fight: I never liked him anyway, so I took the chance to hit him"

To one participant, this described...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT